Profit and cash flow – why it’s crucial to know the difference
There’s a huge difference between and profit and cash flow. It’s important to have a solid understanding of both metrics, whether you’re a new entrepreneur or an established business owner,
Confusing the two can have dire consequences. Some businesses are hugely profitable but are so short of cash they can’t cover day-to-day costs. Indeed, this is especially true of many profitable businesses forced to cease trading because of lockdown.
Here are a few things you need to consider…
WHAT IS PROFIT?
The profitability of a business is measured by examining the income and the expenses. Put simply, if your income exceeds your expenses, then your business is profitable.
On the other hand, if your expenses exceed your income then your business is making a loss.
WHAT IS CASH FLOW?
This refers to the total amount of money that’s flowing into and out of the business. Your business is cash positive when, overall, it has more money coming in than going out.
A negative cash flow on the other hand, means that more money is going out of the business than coming in.
CASH FLOW V PROFIT
A profitable business and a cash-flow positive business are not the same thing. However, they are interconnected. Your business can be profitable but not cash flow positive in the same way that it can also be cash flow positive but not profitable.
Profitability gives a great general overview of the finances of your business. Profit is also important because if you’re achieving profit each month, then you know that your business model is working.
In other words, because income exceeds expenditure, you’ve proved the viability of your business model, and that’s important for any business.
However, in terms of the day-to-day survival of your business, profitability can be misleading. Net profit doesn’t tell you whether you have any cash in the bank or not. Cash flow, on the other hand, tracks money in and money out in real-time.
ACCRUAL ACCOUNTING AND THE CASH FLOW GAP. AN EXAMPLE
The following example illustrates the difference between profitability and cashflow. It also highlights the importance of scrutinising how much cash you have in the bank.
Let’s say you run a business selling furniture and your total turnover last year was £300,000. Your total expenses, including cost of sales, payroll and all other expenses came to £275,000. That means your business was profitable and achieved a £25,000 profit.
However, like most businesses when your accountant prepares your year-end accounts, they use an accepted method of accounting called accrual accounting. This is simply a way of recording all the income and expenses that are incurred by the business, rather than simply recording monies received in or monies paid out.
So for instance, in this example, at the end of the accounting year, you know you are waiting for payment of an invoice for £35,000. This is because you’ve sold furniture to a hotel, who hasn’t yet paid your invoice.
Using the accrual accounting method, this £35,000 invoice is included as part of the turnover of £300,000 mentioned above.
However, as the business owner, you know only too well, that the £35,000 invoice hasn’t been paid yet. You don’t have that money and there’s a big hole in your cash flow.
Now, let’s put the accrual accounting to one side for a moment and look at the cash flow issue you face. Bear in mind your expenses for the year were £275,000 and the income was £300,000.
But remember, you have an outstanding invoice of £35,000 which means that in cash terms you have only received £265,000 in that accounting year. (i.e. £300,000 less the £35,000 unpaid invoice). And because your expenses were £275,000 it means your cash flow is in fact in negative territory to the tune of £10,000.
In summary, the net profit calculation looks like this:
Turnover of £300,000 less costs of £275,000 = a net profit of £25,000
Whilst the cashflow calculation looks like this:
Cash received of £265,000 less costs of £275,000 = a negative cashflow position of £10,000
This simple example illustrates that it’s possible at the end of a financial year to have made a profit and yet be in negative territory cashflow wise.
MONEY TO RUN AND GROW YOUR BUSINESS
Positive cash flow means you have money available to both run and grow your business.
Negative cash flow means you don’t have enough money available to run your business and certainly no funds available to grow the business.
For your business to be a success, it needs to be cash flow positive. And an important by-product of positive cash flow is that as the business owner, you’ll have a much better night’s sleep!
Indeed, the importance of cash flow is highlighted by the recent Government schemes to help businesses survive lockdown.
All of the measures, from Coronavirus Business Interruption Loan Schemes (CBILS), the Furlough Scheme to Bounce Back Loans, are all about keeping cash flow going when businesses can no longer trade.
These schemes aren’t focussed on turnover or profitability – but rather ensuring cash continues to flow so that businesses can survive and hopefully come out the other side of lockdown ready to trade.
So, while it’s important that your business is profitable, don’t forget, it needs to have enough cash flow to continue trading.
There’s a truism in the saying turnover is vanity, profit is sanity, but cashflow is reality.
Until next time…